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Managed Futures - How to Pick a Commodity Trading Advisor

Managed Futures - How to Pick a Commodity Trading Advisor



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Published by zmktwzrd
This article describes techniques useful when investing in managed futures and when choosing a Commodity Trading Advisor.
This article describes techniques useful when investing in managed futures and when choosing a Commodity Trading Advisor.

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Published by: zmktwzrd on Jul 05, 2008


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Over the last seven years the money professionally managed in thecommodity futures markets has more than quintupled! According tohedge fund tracking firm Barclays, assets under management rosefrom about 41 billion dollars in 2001 to more than 219 billion dollarstoday!As worldwide demand for commodities continues to heat up andmore investors (institutional and individual) start seeingcommodities as a sensible investment vehicle, this trend is expectedto continue. This growth has also raised the need for ways to selecta commodity trading advisor. In this article, we will outline what webelieve are some of the best tools, and methods available to theindividual investor when choosing a managed futures product.Let's first define what managed futures are and what they are not.Managed futures are not stocks or ETF’s that just invest incommodities. Managed futures accounts are investments in whichfunds invest in mainly leveraged, future dated contracts forcommodities or financial instruments. Commodities can includesectors such as food, energy, raw materials and financialinstruments like interest rates and stock indices.The leverage, risks and rewards can be (but are not always)substantially higher when investing in the futures markets vs. thestock market. The National Futures Association and the CommodityFutures Trading Commission regulate managed futures investmentsin the United States (unless the firm / fund have “exempt” status).Regulated firms hold a Commodity Trading Advisors (CTA’s)orCommodity Pool Operators (CPO’s) license, but keep in mind, justbecause a firm carries a license is in no way an endorsement of future performance. Futures trading can carry large potential risksand is not for everybody. Investors should be familiar with all therisks before investing.Finding lists of potential managers to sort through is fairly easy if you know where to look. Firms such as Barclays Trading Group,Stark Research, Autumn Gold and Altegris Investments havedatabases of manager information available. One resource we like iswww.autumngold.com. AutumnGold summarizes a free (withregistration) online database of over 450 programs. Also, theprograms can be sorted by a wide range of parameters such asminimum account size, funds under management, and variousperformance measurements.
The only problem we see with the online databases is that it canbecome somewhat overwhelming to try and narrow down yourchoices to just a handful of managers. To help simplify the process,we would like toshare what we think are some of best performancemetrics.Our first recommendation is to forget return! The least significantstatistic often is a manager’s return. How can that be you ask?What matters is RISK ADJUSTED RETURN. Just because somebodybet the farm and got lucky does not mean it was a nifty idea.Sooner or later (most often sooner) the inevitable wipe out willoccur with a manager betting too aggressively.There are many traditional risk adjusted return measurements, themost popular of which being the Sharpe ratio. The Sharpe Ratiocompares the return relative to the underlying volatility in theinvestment. Although we are in agreement with the Sharpe Ratio’slogic, we feel it has one serious flaw. The flaw is that the SharpeRatio only views past volatility and does not try and predict futurevolatility. As a result, we feel the Sharpe ratio does not give anadequate view of the potential risks involved in a program.A good example of this comes from the world of the “option writers” (those who sell options). Since most options end up expiringworthless, it is not uncommon for managers that sell options tohave excellent Sharpe Ratios. They can have smooth looking equitycurves that have produced for many years, but just because anequity curve looks smooth and consistent does not mean it will staythat way. What happened is meaningless if you do not have thesame results. Option sellers with longer term excellent track recordstend to have quick, spectacular “blowups”. The problem, in ouropinion, is that past volatility is not a reliable predictor of futurevolatility.What is a reliable predictor you ask? In our opinion, one of the bestvolatility predictors is the “Margin to Equity Ratio” (MTE). The MTEtells you roughly how much of your investment would be used formargin purposes. This number will vary day-by-day fora givenmanager, but you can get the average range. If, for example, amanagers MTE is 10%, this means that for every $100,000 youinvest the manager uses about $10,000 of this for margin. Keepthis in mind; the exchanges set margin based on theirapproximations of risk. The higher the exchange perceives the riskin a contract the higher the margin they set. We encourage you tothink just like the exchanges and raise your expectations for
potential risk as the MTE goes higher. If we go back to the exampleof the option writers with exceptional Sharpe ratios, you will alsosee that they often have high MTE ratios. We believe that thesehigh MTE ratios were the tipoff that could have avoided manydisastrous scenarios. Once again, just as the exchanges often raisemargin requirements as their expectation of volatility rises, so toodo we see the potential for volatility (risk) to be higher as the MTErises.Another important use of the MTE comes down to pure math. If youhave two managers that made a $30,000 return, yet one used$30,000 in margin to do it, and the other used $60,000 in margin todo it, then the results are different. Based on margin usage onemanager’s return was twice as high as the others. This is essentialto keep in mind, because often managers can appear to havesimilar performances, but when you dig down into their marginusage you see large differences.What is an ideal MTE? In our opinion, we do not like to see marginto equity ratios much above 10%. This is on the low end of thespectrum for managed futures accounts and cuts out mostmanagers. Although it is true that low MTE ratios are no guaranteeof lower risk, we feel that, at the minimum, it is possibly a decentgauge of sound risk management. Once again, it is our belief thatasthe MTE rises so does the potential for risk. There is also arelated risk measurement often referred to as “portfolio heat” thatuses similar concepts.In summary, what we suggest is that you compute returns notbased on what the manager reported, but rather based on thereturn on margin (you should also compute the risk and drawdownthe same way). This will level the playing field and allow you tocompare apples-to-apples. We are also in favor of being on theconservative side of the MTE spectrum, for us that means that wewould likely reject any manager with a ratio above 10%. Using thismethod can help you narrow down your list of choices to amanageable number rather quickly. After you have done this then,you can then look and compare all the other risk adjustedperformance measures and further refine your selection. (At thisrisk of this article being too long we will save the other risk adjustedperformance measurement discussions for future installments).We want to caution once again that, in the end, no measure is aguarantee or assurance against risk or losses. Past performance isnot always indicative of future results. Futures’ trading involves

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